Securitization enables income streams of pooled loans, reducing overall risk to lenders. This spreads the risk of both prepayments and defaults, lowering the cost of credit.
Background
Denmark created pooled mortgages, called covered bonds, in 1850. Switzerland followed in 1930.
In 1970 US government pseudo-agency Ginnie Mae (GNMA) created the first securitized pool of home mortgage loans. GNMA pooled home loans explicitly backed by the US government; typically loans for military veterans, farmers, or other public-policy types.
Another pseudo-US government-owned company, Fannie Mae, issued the first collateralized mortgage obligation in 1983. Louis “Lou” Ranieri, who started his Wall Street career in the mailroom, famously enabled that first bundle of loans.
These early securitizations existed to manage prepayment risk. That is, banks rely on payments over a long period at a set interest rate. If interest rates decrease, and many people refinance and pay off their loans, the assumptions prove incorrect. Pooling the loans lowered overall prepayment risk.
Michael Milken
Subsequently, Michael Milken, an employee with the Drexel Burnham Lambert investment bank, reworked securitization to diversify default risk, not just prepayment risk. Pooling enabled Milken to sell otherwise high-risk “junk” debt because the risk of default was spread. Ranieri followed up w/ MBS’s that diversified both prepayment and default risk.
Milken’s securitizations enabled financiers to purchase businesses with debt eventually assigned to the business. Oftentimes, existing management opposed these purchases, called colloquially “hostile takeovers.” New management, burdened with the new debt required to acquire the company, thenslashed costs by laying off workers and selling assets. Notable hostile takeovers include Pan American World Airways (Pan Am), Revlon, RJR Nabisco. Bankers engaged in hostile takeovers were known as “raiders”. Over time, the name evolved to the more tasteful “private equity.”
Louis Ranieri Mortgage-Backed Securities
Mortgage securitizations grew steadily larger and more complex over time. Eventually, bankers believed they could mitigate virtually any risk of prepayment or default, extending credit to virtually any borrower no matter the risk. Subsequently, this led to irresponsible lending (and borrowing) which, combined with a type of derivative insuring the securitizations (“credit default swaps”) caused the Great Recession of 2008.
Modern securitizations encompass an enormous amount of the world banking system. They manage prepayment and default risk for every imaginable rent stream and also recapitalize early lenders. The securitization market is so large it been labeled a “shadow banking system” due to the immense amount of capital involved.